Matthew Notowidigdo: Revisit Bankruptcy Reform

What’s something that you think will or should be a priority for the Biden administration?

I’m looking forward to renewing the debate about bankruptcy reform. Right now the focus is on student loans, which to my knowledge are the only debt that can’t be discharged in bankruptcy. But [Massachusetts] senator Elizabeth Warren, toward the end of her presidential campaign, produced a detailed policy brief about how she would reform the bankruptcy system, and that is a template for what I imagine the progressive wing of the Democratic party would view as a starting point.

Warren, who was then a Harvard law professor, and President Biden, then a senator from Delaware, were on opposite sides of the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act, which made it harder to file for bankruptcy. Filing used to be a rare occurrence, but in the 1980s and ’90s, bankruptcy rates started to take off. Around the early 2000s, about 1 percent of households every year were filing, plus there were a couple of high-profile examples of abuse. Policy makers started to feel like the system was being used by people who didn’t need it, and their concern was that the bankruptcy rate was spiraling out of control. The bill made it costlier, more of an ordeal, and less financially beneficial to file for bankruptcy.

Biden supported it. Warren was a critic of it, and its passage inspired her to run for senate. My research with Boston University’s Tal Gross, Harvard’s Ray Kluender, the Consumer Financial Protection Bureau’s Feng Liu, and University of Illinois’s Jialan Wang examines what bankruptcy reform actually did—and who was right about the BAPCPA.

In different ways, both of them were: Biden was right in that consumers benefited. Some of the cost savings got passed along as lower credit-card interest rates and lower borrowing costs. But Warren was right in that the law was titled abuse prevention, and it’s hard to prevent abuse.

Our research suggests that reductions in filings have happened across the board, and even people who have had some adverse event such as an illness or injury have had a much harder time filing for bankruptcy. It is unfortunate that the BAPCPA passed in 2005, and just a few years later we had a financial crisis. Many people affected by the crisis ended up facing insolvency and foreclosure. But even now, many people whom we would expect to file for bankruptcy don’t, and they aren’t able to get a fresh start.

I don’t think that’s what the proponents intended. The administration should start there and roll back parts of the law so that people can get back on their feet after they experience adverse shocks. Now a lot of people suffering from illness, injury, or divorce aren’t able to repay their debts.

The idea of targeting people who are abusing the system is a good one. It’s just a hard problem to solve. Using income as a basis to determine who can file didn’t work well. Maybe, 15 years after that initial stab at it, we can find other ways of looking at this.

Matthew J. Notowidigdo is professor of economics at Chicago Booth.